Institutional investors should not rush into factor-based investing, the hot new thing being offered by many money management firms.
In particular, executives who are fiduciaries under ERISA must carefully examine the particulars of the factor-based strategies being offered to them, and how they fit the needs of the funds they oversee.
Asset owners might be forgiven for suspecting that factor-based investing is simply a rebranding of what a few years ago appeared on the market as smart beta.
Factor-based investing examines what factors drive risk in portfolios and seeks to capture the risk premium in those factors that are inefficiently priced.
Before jumping on to the factor-based investing bandwagon, fiduciaries must do their homework.
For example, since managers use different models for measuring factor risk and determining which factors are incorrectly priced in the market, the fiduciaries must examine the models of the managers, using outside expertise if necessary, to ensure the managers can deliver what they promise, usually higher risk-adjusted returns.
The fiduciaries should remember that over the years there have been many wonder-products that would reduce portfolio risk while generating healthy returns, including for example, market timing, portfolio insurance, portable alpha and, most recently, hedge funds.
In each case, except portfolio insurance, some managers were able to deliver the promised risk-adjusted returns, at least for a time, but many were not.
In addition, when large amounts of assets flowed toward even the valid products, the market inefficiencies the managers used often were arbitraged away. So it likely will be for factor-based investing.
In short, fiduciaries should take with a grain of salt the promises being made by managers offering factor-based investing. The must examine the products with an appropriate amount of skepticism and due diligence. n
